Two Year-End Tax Moves for Your Investments

By Tom Martin, CFP®, CPWA®, AIF®, and Andrew Parker

With December 31st right around the corner, now is the time to consider some important year-end tax moves. These two potential tax-saving strategies could help reduce thousands of dollars in unnecessary future taxes.

If, like many physicians, you find yourself regularly having to pay Alternative Minimum Tax (AMT), this may present you with an opportunity to convert your Traditional IRA to a Roth IRA (or a portion of it) at a lower tax rate of 26% or 28% instead of a future potential tax rate of 40%+.

To check your own situation, check line 45 on your 2011 Federal 1040. If you have an amount greater than $0, this strategy may likely apply. If not, and little has changed for your taxes from last year to this year, don’t waste your time with this strategy.

Presently most physicians fall into either the 33% or 35% marginal tax bracket. That means on the next dollar of income you earn, you should owe this percentage in taxes. Here’s where your marginal tax bracket is affected. A conversion from a traditional IRA (funded with pre-tax dollars) to a Roth IRA should normally fall into your marginal income tax. However, if you are being hit with AMT, your effective (average) tax rate is falling below the 26-28% threshold, and therefore you are being charged this alternative minimum rate instead.

Here’s where the strategy comes in. If you are being hit with AMT, when you convert your traditional IRA to a Roth IRA, as long as the dollar amount on the AMT line of your tax return remains positive, you are actually paying 28% or less on the conversion, regardless of your marginal tax rate.

How to do it:

Have your CPA or tax program run a proactive projection of what your 2012 tax return should look like.

If you find yourself with anything on the AMT line (line 45 for 2011 but could change for 2012), have your CPA or the program build in an IRA conversion.

If the amount in the AMT line goes to $0, you have converted too much, and part of your conversion is being hit with your marginal tax rate instead of the lower AMT rate. Note: This isn’t always a bad thing, but the analysis on whether a non-AMT Roth conversion makes sense or not is beyond the scope of this post.

If this happens, rerun it with a smaller conversion amount. Keep doing this until you get a value in line 45 greater than $0. This will show that you are paying the lower AMT rate (maximum of 28% on your conversion).

With marginal rates scheduled to go up in January, this could save you as much as 12% in Federal tax on your IRA conversion. Remember that after converting, the funds in the Roth IRA should grow on a tax-free basis moving forward, and you should be able to pull these funds out tax-free for retirement, provided you follow the IRS guidelines.

Strategy #2: Locking in a Lower Capital Gains Tax in 2012

The second tax move to consider prior to year-end is locking in a 15% rate on long- term gains in your taxable (non-qualified) investment accounts. Beginning on January 1, 2013, long-term capital gains rates are scheduled to increase to 20% or 23.8%, depending on your income.

Take the following recent example for an emergency medicine physician: He has a gain of $50,000 on one investment that he’d purchased years ago. He still wants to participate in the investment, but wants to maximize tax efficiency.

He could simply liquidate the investment in 2012, and then repurchase the same stock moments later. The net effect: on the $50,000 gain, he would owe 15% in Federal taxes ($7,500). If he waits until 2013, this $7,500 tax bill could go up to as much as $11,900. That’s a 58% increase in taxes owed on the exact same investment gain.

Three points of clarification:

Capital gains rates are only going up to 20% in January. We arrive at 23.8% by adding on the additional 3.8% Medicare tax that takes effect beginning January 1 for married taxpayers with incomes in excess of $250,000 (or $200,000 if single).

These higher tax rates haven’t actually materialized yet. This jump from 15% to 20% was supposed to happen on 1/1/2011 but Congress intervened on December 17, 2010 to prevent it from happening. The impact of this strategy could be lessened if Congress changes the tax code.

Some of you may be thinking appropriately, “Isn’t a dollar today worth more than a dollar tomorrow?” In essence, you’re trying to quantify the cost of paying a 15% tax rate today with the idea of allowing those tax funds ($7,500) in our above example, to continue to grow tax deferred. You’re right in this assessment that we need to factor in the cost of paying taxes today. In accounting, this process is called “discounting.” We need to figure out what the future value of the taxes paid today, could have grown to later. From here we can analyze if this is enough to offset the 58% larger tax bill. The result of this discounting equation shows that you are likely better off to sell the position and pay the taxes today if you already plan to do so sometime in the next 5-10 years. If you plan to keep the investment for longer than 5-10 years then keeping the funds invested (instead of paying taxes today) actually turns out better.*

A note of caution: selling an investment, and paying long-term capital gains tax rates, can sometimes trigger AMT taxes to be owed. When this happens, you’re trading your 15% rate for a 26-28% already discussed. This is not a good idea.

Therefore, to implement this strategy, make sure that your CPA or tax program first run a mock projection. You want to make sure you don’t accidentally trigger AMT, and thereby completely erase all benefits of this strategy (paying 28% on the gains instead of the 15% you are expecting to pay).

Tax Projections

Year-end tax projections are essential anytime you are considering implementing a strategy for the purpose of minimizing tax expenses. Schedule this exercise annually for November to give yourself plenty of time to take action if you find that a strategy works well for your situation.

Congress still has much work to accomplish prior to year end. Check back for the latest updates.

*This analysis is dependent on the growth rate earned on the investment. The higher the growth rate the shorter the time required before it is better to delay the taxes rather than pay them today. If the investment return is around 5%, the breakeven point is closer to 10 years, whereas an investment earning 10% would have a breakeven point closer to 4 years.

This information is provided for educational purposes only and should not be considered tax advice. Each individual’s tax situation is unique and you should consult your tax adviser prior to taking any action.